When you retire, you need to invest your accumulated retirement savings sensibly, so that your capital lasts for the rest of your life and you are able to draw the income that you need from this. One of the options is to invest your retirement savings in a living annuity. In this article, we explain the factors that you should consider when you determine what income (also known as your income drawdown level) you should be taking from your living annuity.
What is a living annuity?
A living annuity is a retirement investment vehicle that invests in underlying funds (unit trusts) and then pays out income to the investor over time.
A living annuity gives you the benefit of market growth, but is also subject to market risks
You can buy a living annuity with a single lump sum, or you can make payments into a living annuity before you retire. When you retire, the living annuity makes regular payouts that provide you with income. However, investing in a living annuity does not guarantee a regular income. Rather, the value of your capital is dependent on two things:
- The performance of the underlying unit trusts you choose;
- A reasonable income drawdown level.
If you don’t want to take on the risks of being exposed to the ups and downs of the unit trusts in which your living annuity is invested (where returns are dependent on investment markets), you should consider buying a guaranteed annuity from an insurance company to provide you with a guaranteed (but fixed) income.
Achieving a balance between investment returns and income is essential
Living annuities provide retirees with greater investment choice and income flexibility than guaranteed annuities, but the capital is exposed to investment market and inflation risks. Retirees who invest in living annuities must closely manage the balance between their chosen investment portfolio and the respective returns with the income they draw. That way, you will have enough capital to last your lifetime and still be able to leave any remaining capital to your beneficiaries.
When deciding how much income to withdraw from your living annuity, consider these three factors:
Factor 1: Life expectancy
Studies show that average life expectancies are increasing. If you draw too high an income from your capital and your underlying investments don’t generate enough growth to compensate for the income you are taking, you run the risk of your capital running out before you die.
Factor 2: Inflation
You must take inflation into account in your retirement plan to protect your capital over the long term. Certain costs, like healthcare costs (which is a big expense during retirement), increase by more than inflation, year-on-year. It is therefore crucial that your returns are above inflation (that is, that you earn a real return).
For example, let’s say you have R100,000 today. In 30 years, if you haven’t invested your money or earned a return on this, the same rand amount would have the purchasing power of R15,626. This is based on an inflation rate of 6% per year. This is a drastic reduction in the value of your money.
Factor 3: Expected performance of the living annuity investment
To choose a suitable investment portfolio as a retiree, you must decide what mix of asset classes would suit your risk profile. We recommend that you contact your financial adviser to help you understand and assess your risk profile. The mix of assets that you choose will determine the expected return and risk outcomes for your money. South African investors have become accustomed to generating double-digit returns and even high real returns from most asset classes over the last few decades. This has meant that retirees have been able to draw an income of more than 5% without inflation eroding their capital. However, we are now facing a very different environment, where single-digit real returns are expected to be the norm. It is always very important to remember that the risk warning that appears on all marketing literature about unit trusts is true: past performance is not an indicator of (and definitely does not guarantee) future performance.
Understanding and determining a suitable income drawdown level
A low-equity type of portfolio, such as the Prudential Inflation Plus Fund, aims to achieve an annualised return of 5% above inflation over a rolling 3-year period. If the fund achieves this return, investors could draw an income of up to 5% (including product and advice costs) and their capital wouldn’t be eroded by inflation.
In the last edition of Consider this, John Kinsley wrote about a rule of thumb method for determining your income drawdown as proposed by an adviser: “The adviser said that ‘anybody drawing from a living annuity should take their age and divide it by 10. Therefore, if you’re 50 you shouldn’t draw more than 5%; if you’re 80 you shouldn’t draw more than 8%’.”
What we offer: Prudential Income Portfolio (PIP) Living Annuity
The PIP Living Annuity provides retirees with the flexibility to manage their retirement funding to suit their personal requirements. It is specifically designed to ensure that all annuity payments and annual fees are deducted from the income generated within the portfolio. Only if there is insufficient income at any time will we deduct the balance of the required withdrawal or fee from the capital. This allows investors to manage their personal income needs while protecting the value of their capital.
Investors can choose between three income levels: the 2.5%, 5% and 7% income options. More than 7% isn’t advisable due to the lower expected returns going forward. With the 5% Managed Income Option, which is compliant with the relevant legislation, we are required to manage each portfolio to achieve the targeted income objective of a 5% real return over time.
A case study of a client who invested in the PIP Living Annuity 5% Managed Income Option
We manage this portfolio with the objective of achieving a 5% real return (return above inflation). The client invested R273,887 in July 2009. The red bars at the bottom of the graph show the income generated by the annuity. An initial monthly income of R1,118 was paid at the end of July 2009, increasing to R1,426 at the end of June 2013. The client’s capital value (after the deduction of annuity income and costs) has grown to R389,555 as at 30 June 2013. The graph also shows how this investment option, using a blend of assets across equities, bonds, cash and property, outperformed money market investments over the period.
Retirees should keep a close eye on the balance between the returns generated and the level of annuity income they draw
By being invested in a suitable portfolio (such as the 5% Managed Option), and by not drawing more than the real return objective (which is 5% in this option) and taking into account costs of investing in the product, you can receive a suitable annuity income and increase your capital.
Source: Kinsley, J. “Cautious optimism is the name of the game in 2013.” Consider this, Autumn 2013 edition